New economic policy: If you haven't got enough of this stuff, just print some more

22:35Wednesday 17 December 2008

KEEP up at the back. The new big thing to save the world economy is "quantitative easing". Not an upmarket euphemism for a massage, but the latest and most desperate measure yet by central banks to stop a severe recession turning into depression. And it may soon be adopted in the UK.

Quantitative easing is the elegant, sanitised term for the process by which a central bank fends off the threat of deflation by effectively printing new money, or increasing its supply.

A simple model would work like this: the government issues bonds and sells them, directly or otherwise, to the central bank. The bank creates new money for this purpose and pays the government for those bonds. The money is then used by the government to stimulate the economy through public works and infrastructure projects.

Magic new money: have we really walked into this Last Chance Saloon? Yes, we have.

In an extraordinary statement on Tuesday evening, Ben Bernanke, chairman of the US Federal Reserve, announced he was cutting the Federal Funds rate, the bank's key interest rate tool, to a record low of between zero and 0.25 per cent. That's zero, as in nothing. Not even in the Great Depression were interest rates in the United States brought so low.

However, it was the accompanying statement that let the move to "quantitative easing" out of the bag. He said the Fed "will employ all available tools" and would buy "large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets". ("Agency debt" is a bond, issued by a US government-sponsored agency, such as the Federal National Mortgage Association, or Fannie Mae.)

He also let fall that the Fed would consider buying "longer term Treasury securities" – the government's own debt. This would enable the Fed to bring down the long-term cost of money, thus bringing down US mortgage rates, to put more money into circulation and, not least, to bail out the government by soaking up some of its exploding deficit.

Why has the Fed been driven to adopt such an extreme measure? It fears the US economy will be caught in a "liquidity trap". This is when interest rates are brought close or equal to zero but there is no stimulus effect on the wider economy. People are fearful of buying assets of any sort and keep their savings in short-term cash bank accounts rather than making long-term investments. This makes a recession even more severe, and can contribute to deflation.

But where is the evidence to suggest we are facing a crisis on this scale? The economic losses so far have been no bigger than in previous post-war downswings, so comparisons with the 1930s may seem overblown.

There has been a severe financial crisis that has brought down some of the biggest names in the US financial sector while triggering here a government rescue of three of our biggest banks.

In 1930, the US entered a severe recession but it was not until 1931 and beyond that it turned into a deep depression. Hundreds of banks failed, confidence drained from the economy and unemployment soared to one in four of the workforce. This is the nightmare "quantitative easing" is being brought in to avoid.

Could it be used here? Yes. The Bank of England could expand its balance sheet and buy assets ranging from government debt to corporate bonds. The additional cash in the system could help lower interbank rates.

But why has "quantitative easing" not been wheeled out until now? It carries huge risks. One is that it lets the inflation genie out of the bottle and could spark hyperinflation. It also casts central bank independence to the winds and puts enormous financial power into the hands of government with the attendant risks of "crony capitalism" and corruption.

And finally, there is no guarantee that it works. The US government deficit soared to 9 per cent of GDP under the Rooseveltian New Deal – but the economy slumped back into recession in the late 1930s.

However, as unemployment rises, the political pressure to resort to "quantitative easing" will intensify. Mr Bernanke has summed up the global policy mood in three short, dramatic words – "all available tools".

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